This being the Year of the Goat in the Chinese zodiac, 2015’s personality is supposed to be calm, gentle and mild-mannered.
While the stock market’s mellow returns through mid-year have followed this destiny, the macro background has not yet gotten the message.
Each day brings its crisis de jour, drawn from a rotation that includes: the Federal Reserve’s rate increase pacing, collapsing oil/commodity prices, Chinese stock market declines, Greek default, and economic growth fears.
On top of that, there’s the stronger dollar, narrowing stock market breadth, U.S.-Iran nuclear negotiations followed by what will likely be an epic Capitol Hill approval battle, and posturing in front of the 2016 presidential election.
Volatile Markets
After a remarkably strong six years for the stock market, how can one intelligently invest with so much boiling in the background?
We’ll be the first to admit that we don’t know how each of these issues will unfold. We’re not in the prediction business.
Our sole focus is to find undervalued corporate assets that are undergoing strategic transitions that we believe will bring new long-term prosperity to shareholders.
Staying Focused
Each of our current holdings was selected specifically because their long-term futures are driven primarily by what they can influence.
We are talking here of the productivity of these companies’ people and their intangible assets, their competitiveness and profitability, their balance sheets.
However, our concentrated Event-Driven SMID Cap Value portfolio of very un-benchmark-like holdings produces short-term performance that will frequently diverge from the market return.
Departing from the comfort of following near-term macro sentiment can produce near-term anxiety. We’re happy to accept this volatility and divergence.
Time Horizon
Over our three to five-year horizon, the benefits of successful execution of our companies’ transitions should overwhelm the impact of fluctuating big-picture sentiment in our opinion. In the long run, micro prevails over macro.
The Event-Driven SMID Cap Value portfolio returned -0.25% in the second quarter4, ahead of the -1.27% return of the benchmark Russell 2500 Value Index. The S&P 500 Index returned 0.28%.
We mention the S&P500 as it is a widely-used broad market reference point.
Small-Cap Bias
However, our strategy focuses on a much smaller cap segment: the average market cap of the Russell 2500 Value is $3.8 billion, whereas the S&P 500 average is ten times larger at $38 billion.
The S&P 500 includes companies like Apple with its $720 billion market cap and leadership of the entire technology industry – very different from the types of companies in our small- and mid-cap segment.
In the quarter, a few holdings had notably strong returns, yet there were no meaningfully weak names. Most of our positions showed only incremental changes in their share prices.
Sector Strategy
As long as the fundamental transition continues on track, the interim share price movement is mostly a distraction – unless it offers us an opportunity to add to our position on unwarranted price declines.
At the sector level, our Industrial sector holdings produced strong contributions.
Reflective of the somewhat subdued movement in our individual stocks, there were few meaningful positive or negative contributions from other sectors.
Low Turnover
We held 36 positions at quarter-end, adding four new names in the quarter and closing out one position.
Reflecting our low-turnover approach, our annualized turnover rate in the quarter was 30%. For the first half of 2015, the annualized turnover rate was 25%.
As investors in our own strategy, we are highly-attentive to maximizing tax-efficiency.
Cash Position
The period-end cash balance was 8.1%, slightly lower than where we started the quarter (at 9.8%).
While the number of corporate transitions in the market remains strong, we remain diligent in our discipline.
We want to invest only in what we believe are the most promising ones, and at valuations that produce a margin of safety.
New Opportunities
As the transition segment evolves, we continue to seek what our research indicates are new opportunities for attractive investment.
With spin-offs, the current opportunity is two-fold: strong activity and better pricing.
In the first half of the year, for example, companies distributed over $50 billion in shares to investors, up 25% compared to a year ago, according to our research.
And, during the 3-day period around June 30, ten companies executed spin-offs.
Although these numbers are unlikely to increase further, we see levels remaining strong.
Spinoffs
Pricing has improved on spin-offs, for a few reasons:
First, previously rising investor enthusiasm had pushed many pre-spin valuations to well-above reasonable levels. These are now falling back to more attractive levels.
Second, several recent spin-off companies were of lower quality, burdened with onerous capital and dividend obligations or difficult strategic positioning, leaving disappointed investors somewhat soured on the entire group.
In addition, as companies in transition are often perceived as higher risk and more vulnerable to macro concerns, investors tend to sell these shares first in periods of risk reduction.
Activists
Similarly, transition stocks can attract short-term traders – who may be forced to sell their holdings to raise capital.
Each of these factors contributes to more attractive entry points for investing in post-spin-off companies.Activist-led prodding of underperforming companies continues to be another strong source of investment opportunity.
Activist funds hold growing amounts of firepower and are experiencing better receptivity by old-guard companies, and have garnered more broad support from large mutual fund firms whose backing is vital to activist success.
Combined with generally more civilized public behavior by activist managers, shareholder activism appears poised to be a permanent feature of the market.
Transition Stories
Opportunities presented by new management transitions remain abundant, particularly as change begets change.
In the food industry, for example, the recent merger of Kraft Foods (KHC) and Heinz is pressuring all food companies to change their cost structures.
As consumer preferences for fresher foods with healthier ingredients accelerates, companies across the entire food chain, from farmers to ingredient producers to retail food stores, need to adjust. Management teams that fall behind will increasingly be replaced.
Food Fights
The secular changes we see in the food industry are occurring throughout the economy.
Industrial buyers, consumers, intermediaries – they all have plenty of choices when buying products and services, with Internet-augmented competition adding a new competitive dimension.
We strongly believe new managements, focused on bringing needed changes, will provide a fertile investment environment for years to come.
The investments discussed are held in client accounts as of August 26, 2015. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
